Fed surprises with hawkish tone, but will Yellen?

Markets are now anticipating a more hawkish tone from the Fed, but maybe not from Fed Chair Janet Yellen when she addresses the annual Jackson Hole symposium Friday.

Against the backdrop of the Grand Tetons in Wyoming, the Fed gathers Thursday and is expected to debate the health of the labor market. Minutes released Wednesday from the Fed's July meeting showed that officials discussed raising interest rates sooner, but they continue to disagree on how much the labor market is improving.

Stocks rose after the minutes were released, and the dollar and yields on shorter duration bonds also rose, as traders anticipated a Fed moving to hike rates. The Fed is in the process of unwinding its quantitative easing bond program, and is widely expected to move on raising rates in the middle of next year.

But the Fed broke new ground with its July meeting minutes, signaling that it is thinking about a return to normalcy and potential policy paths to get there. It noted that both employment and inflation are moving closer to mandated goals.

"The biggest thing that was hawkish was they've all been surprised on the upside with how rapidly the labor market has improved," said Mesirow Financial chief economist Diane Swonk. "There is also a split among them about whether wages are accelerating. The staff report says no, but certain regions are saying maybe they are."

The July minutes mirror the recent public comments of Fed officials, with some like outspoken Dallas Fed President Richard Fisher, saying the economy and labor have improved enough to warrant earlier rate hikes. But Yellen, at the core of the Fed, has said while there is improvement, there are still big problems like a large number of long-term unemployed, too many people working just part-time and a low participation rate.

"Certainly there was a sense things happened faster than they thought, which means a faster rate hike, but they weren't willing to pull the trigger. They weren't willing to change guidance yet. They've been fooled more than once by this economy. It's still data driven …They're not popping champagne corks here," Swonk said. Fed officials were concerned about the sharp contraction in first-quarter GDP plus the geopolitical developments that have been unnerving markets.

LPL Financial's John Canally said the Fed's candor in its minutes took the bond market by surprise. "I think they anticipated this week to be another dovefest. I think from a market perspective, they are surprised. If Yellen comes out of the box Friday morning and says there's lots of slack in the labor market and we're not thinking about raising rates, this will all go back out the door," said Canally, investment strategist and economist.

Jay Mallin | Bloomberg | Getty Images

The Federal Reserve

The Fed discussed the levers it could use to get to higher rates, including interest paid to banks on reserves and the target Fed funds rate.

Yellen speaks at the Fed gathering Friday morning, and European Central Bank President Mario Draghi delivers his address that afternoon.

"The Fed's on the back end of expansion and tapering and eventually raising rates. We know the direction. We don't necessarily know the timing and exact details," said Robert Sinche, global strategist at Pierpont Securities. "It's not clear what the ECB does next … Draghi accomplished a lot without doing much."

Sinche said the markets have been anticipating some move by the ECB, as the European economy shows signs of weakening. A form of quantitative easing, or bond buying, is one strategy. "In the case of the ECB and Draghi, I just think there's a lot of uncertainty about unconventional policy," Sinche said. "It's not just a short term policy issue. This is the kind of thing you discuss at Jackson Hole."

As for the Fed, he said it may have intentionally left Wall Street economists off the Jackson Hole invitation list this year in an effort to shift the discussion toward a longer term debate and not make it as policy focused as it was when Ben Bernanke was Fed chair. "I would think she would bias her comments to say as little as possible," he said.

Milton Ezrati, Lord Abbett market strategist and senior economist, said that Yellen's attempt to focus on longer-term issues may in fact make her sound hawkish. "She's talking about the labor market in an amorphous way. It gives her tremendous maneuvering room….If she's like (Bernanke), and I suspect she will be … he always used Jackson Hole to take the longer view. The longer view always sounds more hawkish," he said. "Anybody who has any optimism about the real economy is going to sound hawkish at the Fed."

Besides the Fed Thursday, traders are watching some key data including weekly jobless claims at 8:30 a.m. EST; existing home sales at 10 a.m.; the Philadelphia Fed survey at 10 a.m. and leading indicators at 10 a.m.